Private Equity Funds

A proposed rule has been introduced by the U.S. Securities and Exchange Commission to exempt advisers of venture capital funds and other funds with less than $150 million in private fund assets under management from the registration requirements of the Investment Advisers Act of 1940 that were enacted in connection with the Dodd-Frank Wall Street Reform and Consumer Protection Act.  Without this exemption in place, as of July 21, 2011, all advisers of private fund assets regardless of size would be required to be registered under and comply with the Investor Advisers Act of 1940.

Read the entire alert on the proposed exemption rule.

CEOs are less optimistic in 2010 than in 2009 about private funding in Indiana.  Interestingly, Indiana leaders believe the availability of public funding increased slightly in 2010.

CEOs are also positive about the state's ability to attract businesses to Indiana.  Which means that the state is doing a good job of "selling" Indiana to out-of-state businesses.  The state can bring in business, but can they keep them?  According to the report, yes.  The bottom line is Indiana is making the Hoosier state fertile ground for companies to plant deep roots that will flourish.

The Butler University College of Business, Ice Miller and Inside INdiana Business announced today the results of their fourth annual statewide survey of Indiana's chief executive officers, senior executives and business owners. The survey, "The State of Our Business – A Perspective from Indiana Executives," provides insight and understanding on the significant issues facing the state's business leadership.

The project partners identified 2,420 CEOs and other executive officers as potential respondents. Of those contacted, 428 responded to a comprehensive online survey designed by the Butler University College of Business.

The project partners identified 2,420 CEOs and other executive officers as potential respondents. Of those contacted, 428 responded to a comprehensive online survey designed by the Butler University College of Business.

"The survey found some reasons for optimism," stated Gerry Dick, president of Grow INdiana Media Ventures, LLC and host of Inside INdiana Business. "For example, many CEOs report there is now a stronger likelihood they will pursue adding jobs compared to their outlook in 2009." The survey found that central Indiana companies are more likely to add jobs as are companies with less than $5 million in revenue and those between $10 million and $50 million in revenue.

"We're now seeing several trends emerge as we start to analyze the data over a four year period," noted Byron Myers, chief managing partner, Ice Miller. "Many of the priorities of Indiana executives, with the exception of customer loyalty and retention, received importance ratings that are statistically equal to ratings received in 2009 as well as all past years of the survey. This may be an indication that even in times of major economic change CEOs maintain a relatively consistent structure of priorities."

"This year's CEO survey shows that the general business mood is improving but most CEOs are hesitant to implement solid growth strategies until the economy settles down somewhat," said Bill O'Donnell, director of graduate programs, Butler University College of Business. "We are also pleased that now, with four years of data, we can start tracking trends and see the direction CEOs view the state's economy to be moving."

Study highlights from 2010 include the following:

•  Customer reputation is back on top as the highest ranked business issue. In 2009, the highest ranked issue was customer loyalty and retention.
•  K-12 education and innovation continue to be ranked as the strongest disadvantages for Indiana as compared to neighboring states. Cost of living is still seen as the strongest advantage that Indiana has over neighboring states and has been on the rise as the strongest advantage since 2007.
•  CEOs believe the availability of private funding sources is significantly less compared to 2009.
•  A new question was added in 2010 regarding CEOs' plans to hire workers. There is optimism among CEOs that they will hire in 2010, as adding full-time and part-time workers was ranked above the midpoint on the scale.
•  Having enough time is still CEOs most challenging issue, although keeping up with technology has moved up in the ranking.
•  New questions about social media were added to the section relating to information technology. One-third of CEOs said they have a policy concerning social media usage for employees.

The project partners will continue to benchmark the results from the 2010 survey and monitor, discuss and analyze the state's progress. A full summary of the report can be found online at: www.inceosurvey.com.

In the wake of the recent financial crisis, on May 20, 2010, the U.S. Senate voted to adopt sweeping financial reform.  The proposed Restoring American Financial Stability Act of 2010 would:

• create a number of new governmental bodies designed to protect investors;
• severely limit government bail-outs;
• streamline bank regulation;
• regulate trading of derivatives;
• increase regulation of hedge funds and credit rating agencies;
• affect executive compensation;
• undertake some reform of the SEC;
• strengthen the Federal Reserve; and
• increase regulation of securitization and municipal securities transactions. 

But, could it also affect the availability of private equity funds?

The bill aims to end so-called "too big to fail" bail-outs.  The Volcker Rule is part of that effort.  The rule prohibits banks and their affiliates from investing in or sponsoring hedge funds and private equity funds and otherwise requires limited relationships with hedge funds and private equity funds.  Non-bank financial institutions supervised by the Federal Reserve will also have restrictions on their hedge fund and private equity investments. 

Banks and other regulated financial institutions provide a significant portion of the capital for private equity funds.  Without that capital, private equity funds will likely be smaller and less inclined to make investments.  In many instances, private equity dollars are available to companies seeking funding in circumstances under which traditional banks would not lend.  In those cases, the limited availability of private equity dollars could damage companies seeking funding.  Those companies may not be able to obtain funds for operations, strategic acquisitions or expansion if private equity money is not available.

While the financial reform bill has many legitimate purposes, it may have consequences that were not anticipated by the drafters.  Those consequences will affect not only private equity funds themselves but also companies that rely on private equity as a source of funding.

Congratulations!  You're one of few.  The next step is to negotiate the commitment letter.  There was a great article about negotiating loan commitments in the January/February 2010 issue of Business Law Today.  The article was titled "Negotiating the Loan Commitment:  The Borrower's Perspective" and was authored by John N. Oest.  Below are some of the major points made in the article: 

• Negotiate your important points up front before signing the commitment letter.  You will probably not get another opportunity.
   
• Understand that the commitment letter likely contains a number of conditions to the bank's commitment, and few for the borrower.  Some commitment letters contain an express agreement by the borrower to borrow the funds.
• Negotiate basic financial terms in the commitment letter, including amount of loan, interest rate, maturity date, fees, financial covenants and method of calculation of interest.
   
• Understand at the commitment letter stage how much money will actually be available to you.  For example, if your loan is based on "80 percent of Eligible Accounts Receivable" or some similar formulation, you'll need to understand up front what constitutes an Eligible Account Receivable.  If you do not, you could end up with less money available to you than you expect.
   
• Work through the prepayment rights and obligations at the commitment letter stage.  You may want to prepay the loan, but may find it triggers penalties or  yield protection payments .  Also, you need to understand when you will be required to repay the loan.  Often, an equity raise or a sale of substantial properties outside the ordinary course of business will trigger a prepayment requirement.
   
• Look for a due-on-sale clause.  Most mortgages contain these provisions that require repayment of the loan upon sale of the property.  These may be subject to limited enforceability in some states.
   
• Change of control provisions prohibit transfers of shares of a privately-owned company if the transfer would result in specified percentages of change of ownership.  The borrower should ask for some specific exceptions, including permitting transfers among owners and their affiliates, transfers for estate planning purposes and others.
   
• The commitment letter will generally limit other debt and other liens.  You should negotiate to obtain some standard exceptions such as unsecured trade debt, subordinated debt, intercompany debt, purchase money debt and capital leases.  You may also want to try to get a general basket for unsecured debt in a maximum amount.  With respect to liens, you should negotiate to allow existing liens, liens imposed by operation of law, liens security purchase money debt and other liens. Depending on your company's structure, the lender may require guarantees of the loan.  You and the guarantors will need to understand the scope of those guarantees.  

 
The basic point is, don't take the commitment letter lightly.  The early stage is when the key terms of the credit are mutually established, so pay attention to the details of the commitment letter and negotiate the issues most important to you at this stage.

During the financial crisis, private equity, mezzanine and venture capital firms have spent a lot of time "cleaning house."  The financial crisis has made cheap debt less available and thus private equity and other firms are not able to complete deals with the huge leverage ratios that existed prior to the crisis.  So, they have taken a close, hard look at existing investments in order to determine which could be saved and have allocated resources appropriately.  

This sort of review has included, from a legal perspective, review of debt covenants and commercial contracts.  The firms have wanted to determine which of their portfolio companies are in danger of violating a financial covenant or failing to perform under a critical contract. 

Recent reviews have also included analyses of potential exit strategies in a down economy.  The potential strategies include the traditional options of bankruptcy, sale and IPO.  IPO's have been down sharply until very recently, so this option has not been given much consideration.  Sales have continued, but with valuations low, this is often not a favored option.  Bankruptcy is, as always, fraught with difficulties as firms consider the opposition of creditors as well as the value of their secured positions, if any.

Throughout the financial crisis, distressed investing has continued.  With the credit markets tight, private equity and other firms have taken some opportunities to fund companies that have not been able to get credit in the traditional credit markets.  These efforts persist, and the firms continue to focus sharply on the fundamentals of these companies in order to protect their investments. 

Move over Sarah Palin. While "Going Rogue" may be the talk inside the beltway, there's a new book that has captured the attention of many on Wall Street: "The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis".  The author, Joshua Kosman, forebodes the possible collapse of many companies owned by private equity firms.  While it certainly isn't clear whether what Kosman's is prophesying about will in fact turn into a significant chapter in U.S. history books, it's an interesting read nonetheless.  A short excerpt on NPR can be found at:

http://www.npr.org/templates/story/story.php?storyId=120391729
 

A recent edition of PitchBook News Private Equity: Basic Edition cited a decrease in 2009 in exits from private equity investments through sales to other private equity firms.  The article stated that these secondary sales are down approximately 22 percent from their levels in 2005 through 2007.  In 2008, many private equity exits took the form of sales to strategic buyers.  In 2009, IPOs increased by approximately 19 percent, according to the article. 

So what does this mean?  Late 2007 saw the beginning of the current economic crisis and, in that time, it appears that private equity firms continued to feel confident in investing their money.  In many cases, they did so by buying out other private equity firms. 

In 2008, when it became clear that the economic crisis would not be short-lived or minor, strategic buyers became the most obvious source for private equity liquidity.  Strategic buyers saw opportunities to enhance their businesses through the synergies offered by private equity portfolio companies.  In addition, valuations were very low:  the perfect formula for strategic acquisitions.

In the later parts of 2009, we have seen the public equity markets bounce back significantly.  Instead of shying away from the public markets' previously unequaled volatility and sharp decreases in value, private equity firms looking for an exit option seem to have again turned their focus to the IPO as a possible exit strategy. 

Hopefully, markets will continue to stabilize, valuations will become more reliable and private equity firms will invest some of the money they are currently holding.  If all these things happen, we can hope to see a return of multiple options for private equity exit strategies.
 

Some studies suggest that the answer is  yes!  In a recent study, the Preqin Research Report Private Equity Investor Survey August 2009, many limited partners (LPs) investing in private equity funds reported that the balance of power in negotiations between the funds general partners (GPs) and the LP's had shifted in favor of the LPs.  In fact, according to the Preqin report, in April 2009, 27 percent of investors thought they had greater negotiating power.  Three months later, in July 2009, 55 percent of investors interviewed by Preqin believed they had greater negotiating power.

Why would that be?  Certainly, one of the reasons is that levels of LP investment have fallen significantly from previous years.  According to the Preqin report, private equity funds raised $194.5 billion in the first quarter of 2008, while they raised only $64 billion in the first quarter of 2009.  The GPs have to compete for the limited LP funds that are actually being invested now.  One of the ways to do that is to offer LPs more favorable terms.

So, cash-rich LPs appear to be returning to the market.  Private equity fundraising has already begun to improve in 2009.  According to the Preqin report, $79.7 billion was raised by private equity funds in the second quarter of 2009 as compared to $64 billion in the first quarter of 2009.

The Alliance of Mergers & Acquisitions Advisors and PitchBook Data recently released a study of the private equity industry.  The study showed that there is an overhang of approximately $400 billion in private equity fundraising.  That means private equity firms have raised about $400 billion more than they have invested.  There's a lot of money out there waiting to be invested.  In fact, it's at an all-time high.  Click here to see a copy of the report.

As tough as times have been, people have continued to give their money to private equity funds.  The funds just haven't found companies that they consider good investments.  So what needs to happen?  According to some, it's a matter of companies lowering their expectations.  Companies can no longer expect to get the kind of multiples or the kind of leverage that were used before 2007.  Others say it's all about the stability of the economy and the re-opening of the credit markets.  Still others say that investors need to change the way they do diligence on a company.  The old methods will no longer work in light of the current economic realities.

So which is it?  Probably a combination of all.  Either way, I look forward to the days when we start to use that $400 billion.

As we all know, we are in a recession.  In these difficult economic times, everyone is wondering where we can find money to help start or grow our businesses.  It seems that everyone is holding their money close to the vest.  In reality, however, there are many different places where a company can obtain equity or debt financing to help its business.  The key is understanding what type of money is available.

Traditionally, the first place to find money when starting a new business is from family and friends.  Obviously, investments from family and friends are made in large part upon the relationship you have with those individuals, but you need to be careful to comply with federal and state securities laws.  This usually means that you want to make sure you investors are accredited investors and that you conduct your private offering in compliance with an exemption under Regulation D  of the federal securities laws.  There are limits on the number of investors and the amount of financing a company can receive in order to fall within one of the many exemptions.  Family and friends are still providing capital during the recession, however the amounts that can be raised from family and friends have diminished as individual investment and savings accounts took a beating from the drop in the equity markets over the last year.

If you do not have close friends or families with the available cash to invest in your business, "Angel investors" can be and are a still a great source of capital.  Angel investors are high net worth individuals that can provide large tranches of capital through equity or convertible debt investments.  Typically, angel capital is the second round of capital that start-up companies and businesses receive and can provide capital in the range of $500,000 to $2,000,000 depending on the needs of the company and the willingness of the "angels" to invest.  Although angel investors are more selective in these economic times, angels are still investing and are looking for the right opportunities and the right companies.  Once again, when raising money from angels, you need to comply with federal and state securities laws and structure your offering to comply with on the private offering exemptions.

Venture funding is another source of capital that can be very advantageous for start-up companies.  Venture funding comes at a price.  Generally, venture capital firms will require a seat on the board, veto rights on major decisions such as additional financing and sale of the company, and a high return on their invested capital.  There are numerous venture capitalists looking to deploy money right now.  They are more selective in these economic times, but the venture capital firms typically do have the money to invest.  Venture funding is one of the key types of financing that provides the necessary capital infusion to allow a company to take the next step.

Private equity capital is generally available for more mature companies that are looking to expand and grow.  Private equity investments can take a variety of forms and generally involve a buy-out or a purchase of a majority equity interest in a company.  As with venture funding, there are numerous private equity funds with millions of dollars to deploy right now.

Traditional debt financing from institutional banks is available to companies as well.  The credit markets have suffered through the banking crisis and the recession, but the current administration's policies have encouraged banks to loosen the reigns to start lending money again.  It remains to be seen whether that will work.  A bank will generally require security interest the company's assets including inventory, real estate and/or accounts receivables, pledge of stock or a personal guaranty.  Bank financing will also require meeting certain financial covenants.

When you are raising money for your company, a private placement memorandum (PPM) can be used to provide information to potential investors to help them evaluate the merits of an investment in your company.  It is intended to disclose material information to potential investors about the securities you are selling, your company and its business, in particular, the risk factors associated with an investment in your company.  A PPM is not always required for full legal compliance with securities regulations, but it is a useful way to show that you provided all material information to investors.  Generally, each PPM will include a business plan, risk factors, a description of how you intend to use the proceeds of the offering, a capitalization table and a description of the closing process for the investment.

However, there is no "one size fits all" PPM.  They will vary according to the company's size, industry, development stage, offering size and other factors.  Therefore, it is important that a company offering securities retain competent legal counsel to assist with preparing the PPM and conducting the offering.

Business Plan

The business plan section lets you educate potential investors about your company's strengths and weaknesses.  This section should describe the products and services offered by your company, the needs of the market place, the risks which may be posed by actual and potential competitors, your strategic plans with respect to innovation, marketing and financing, and the overall business environment in which your company will operate during the term of the investment.  In most cases, the business plan section is drafted by you and reviewed by legal counsel.  One of the major purposes of legal counsel's review is to ensure that the PPM, taken as a whole, is not misleading to potential investors.

Risk Factors

The risk factors section of the PPM is a specific description of some of the risks that may be associated with your company, the industry and the particular terms of the offering.  If well drafted, the risk factors section can provide useful protection against some potential claims by investors.  Although the actual risk factors for your company will depend on your company's specific business and activities, there are some fairly standard disclosures found in most PPMs.  For example, a "development stage" company will likely include in its PPM the following as risk factors:  lack of revenue, losses and financing requirements, product development risks, technological risks, manufacturing and distribution risks, dependence on key employees, competition, regulatory risks, potential inability to exercise a redemption right, dilution, no market for shares, and difficulty of determining an appropriate offering price.  The company should also include any other risks relevant to its particular business.

Use of Proceeds

The PPM should include a section that describes how you intend to use the proceeds of the offering.  Naturally, you will want to retain some flexibility regarding the use of the funds, but the investors will likely require at least a general breakdown of uses.  The use of proceeds section might list product development, acquisition of new technologies, facilities expansion, hiring of new employees or general working capital requirements as possible applications of the proceeds.  The key to this section is to strike the delicate balance between flexibility for your company and certainty for the investor.

Capitalization

The capitalization section describes the capital structure of your company.  The capitalization section should include a capitalization table which will allow a potential investor to determine how much of the company he will own (or how much of the company's debt he will own).  The capitalization table should reflect both the actual debt and shareholders' equity of the company prior to the offering, as well as the adjusted figures reflecting the completion of the offering on the terms contemplated in the PPM.

Closing Process

The closing process or subscription procedure (as some refer to it) can be foreign and confusing for investors.  Therefore, it is helpful to provide investors some guidance in the PPM regarding how the closing will proceed.  You can require that a minimum amount of money be raised before you will proceed with the offering.  If that is the case, the PPM should disclose the minimum aggregate capital commitments. After any applicable minimum is met, qualified investors generally have to complete and return a subscription agreement which obligates them to buy the securities, along with a check for the amount of the purchase price (payment may also be made by wire transfer), by a date specified in the subscription agreement.  Sometimes the subscription agreement is included with the PPM.

The investor may also be required to complete and return an "accredited investor" questionnaire to allow the company to comply with certain exemptions from the securities laws.  If required, the questionnaire is typically attached to the subscription agreement. 

After the company has received all signed documentation and funds, it should provide the investor signed counterparts of the documentation.  The company may also provide the investor share or unit certificates or promissory notes, if applicable, and signed copies of the company's governing documents.  If the company is making the private offering pursuant to certain registration exemptions, after the closing it may need to file various documents, including Form Ds and U-2 Uniform Consents to Service of Process, with the state and federal authorities where the investors are located.

As Associated Press business writer Michael Liedtke observed in his October 20, 2008 article Feeling Financial Squeeze, VCs Curtail Investments, “Although a drought hasn't set in yet, it's looking inevitable as the ripple effects of a worldwide financial crisis rattle venture capitalists.”

According to data released by Thomson Reuters, PricewaterhouseCoopers and the National Venture Capital Association, venture capital investments have recently experienced the largest decline since spring of 2003 following the dot com bust.

Many venture capital firms are advising the management teams of their portfolio investments to revise their short-term business plans to reduce costs by laying off staff and trimming budgetary spending in expectation of a worsening recession.

Although venture capital investments have experienced the largest drop off in the last decade, there is a silver lining in the form of a rising interest in biotechnology and alternative energy.  As stated by Terry Kosdrosky in Private Equity Has Toolkit to Ease Troubled Market, “Political leaders and the public are hungry for renewable sources of energy that will lessen the country's dependence on foreign oil and cut down on pollution.”

Venture capital and private equity funds have followed the emerging trend of new companies seeking to stake a founding interest in these industries.  For example, Liedtke cites statistics supporting a 21 percent increase in venture capital investments in biotech startups from last year, while alternative energy, was close behind with a 17 percent increase.

In addition to venture capital opportunities in the U.S. biotechnology and alternative energy industries, Kosdrosky also points to growing opportunities overseas, stating “With growth stunted in the U.S., many private equity firms are looking to put their money to work in growing markets such as China and India.”

The current financial climate has forced venture capitalists to focus their resources on existing investments rather than taking on new challenges.  What does all this mean?  Despite the downturn in the global economy, opportunities for lucrative venture capital investment still exist, albeit in new forms and perhaps in sectors not previously considered.  As blogger Seth Levine wrote in his October 22, 2008 post of VC Adventure, “Be flexible. Seek outside input. Be introspective. Stop and consider what you're learning and if it effects key assumptions behind your business idea. Tweak what you're doing.  Repeat.”

Like the little black dress, socially responsible investing (SRI) is not new but is ever present and constantly updated. The history of SRI includes boycotting of investments in companies that profited from the Vietnam War, avoidance of investments in South Africa during apartheid and, more recently, investment in companies developing sustainable energy strategies, promoting clean water, preventing climate change, producing organic foods, promoting consumer protection and other categories.

SRI can be defined in a number of ways, but it generally refers to an investment strategy that considers not only profit but also the social, environmental or other impact of the investment. This "double bottom line" approach is intended to maximize both financial return and social good. Sounds great. Lots of people seem to think so.  According to a recent study by the Social Investment Forum, approximately 11% of assets under management in the United States are involved in SRI. SRI assets increased from $639 billion in 1995 to $2.71 trillion in 2007.

As particular types of social activism (think environmental preservation) became accepted mainstream societal values, venture funds with a socially conscious agenda are becoming more common.  There's also the growth of so-called "greenwashing" that has likely contributed to the increase in SRI. Companies wanting to cash in on this societal trend may use environmental protection essentially as a marketing strategy. But, the actual operations of the business may not be carried out in an environmentally friendly manner. Your typical investor would not be in a position to know and may therefore not effectively accomplish their identified goals with their investment dollars.

Will the growth in SRI continue?

Hard to say. Funds in SRI, so far at least, have had to be "patient capital." That is, there are no quick returns and the investor should not expect liquidity on the short timeframe that is typical for private equity transactions. SRI funds and SRI companies seeking investment will have to control expectations of their investors as they strive to meet their double bottom line goals. Another concern is that the trend will catch on in a manner reminiscent of the dot com bubble.  Many investors funded dot com companies without adequate diligence and, as a result, many of those companies failed to meet their projected returns. The failure cast a dim light on all Internet-based companies, regardless of their merits as investments.

We can only hope the same does not happen to SRI. The idea of SRI is a noble one. I'd hate to see it fail because we all jump on the bandwagon before the underlying premise has been proven to make for a valuable investment